WASHINGTON, Dec. 3 (UPI) -- Enron's demise calls into question its trading-dominated business model and raises the question of what future energy markets will look like. As always, the excesses of the '90s must be paid for.
It's not the first such event, of course. The demise of Drexel Burnham Lambert in 1990 called in question the junk bond market, which appeared to rest upon a very shaky "back of an envelope" economic analysis done by Mike Milken in the mid 1970s. Yet junk bonds are with us still, and in the 1990s became a worldwide phenomenon, although an Argentina default could potentially dull investor appetites for them for a while.
Both collapses appear to have stemmed from the same essential cause: the difficulty, almost the impossibility, of controlling trading operations adequately.
During the 1980s and 1990s, a number of huge unexpected losses emerged as a result of inadequate controls of trading operations. Merrill Lynch, in 1987, lost $250 million in the mortgage bond market. Kidder Peabody lost $300 million from an unauthorized trader in 1993 and was forced to close. Baring Brothers lost $1.2 billion through a "rogue trader" in Singapore in 1995, and filed for bankruptcy. Sumitomo Corporation lost $2.6 billion in copper futures in 1996. And of course, the granddaddy of them all was Long Term Capital Management, rescued by an extraordinary Fed bailout in 1998, when its derivative positions totaling more than $1 trillion nominal went wrong.
LTCM was said at the time to threaten the stability of world markets; in retrospect this seems extraordinary, since, unlike Drexel, it controlled no significant market sector, nor had it innovated in anything but the scale of its operations and the arrogance of its executives. Much better to have allowed LTCM to collapse, and to have rescued Citigroup, Goldman Sachs, or whichever else of the big Wall Street houses might have been threatened by such a collapse. The result of the bailout, and subsequent easing of Fed interest rate policy, was to prolong by a further eighteen months a stock market and economic bubble that was already way out of control, and to increase hugely the "moral hazard" tendency of banks to get themselves into trouble and expect the government to bail them out.
For Drexel in 1990, as for Enron today, the case for a bailout was somewhat better. Both companies were instrumental in creating entire new markets, and in both cases there was (is) some question whether the new markets, of proven economic usefulness, will survive their creators. Moreover, in 1990 as today, but notably not in 1998, the U.S. economy as a whole was looking distinctly shaky. Nevertheless, like Drexel, Enron has been allowed to go to the wall, and "moral hazard" has thereby been significantly reduced.
It's always difficult to foretell the future, but it would appear that the trading markets in energy, oil and even "bandwidth" are most unlikely to disappear. They have been created by the huge increase in computing and communications power of the 1980s and the 1990s, and neither the technology that permitted them nor the economic advantages that fostered them are going away anytime soon. In certain commodities, for limited periods, the Gray Davises of the world may get their way, and national or local governments may re-regulate the markets in a populist attempt to protect the consumer. After all, for 40 years after the 1930's, the Federal Reserve Bank regulated interest rates, through Regulation Q, in a way quite unimaginable today.
Nevertheless, the cost advantages of being able to deliver say electricity in any quantity and over any period it is needed, which have been made possible by Enron and its competitors, are simply too compelling for even politicians to resist forever, even in a recession.
One thing that is likely to change, however, is the names of the participants in traded energy and "bandwidth" markets. The collapse of Enron has demonstrated graphically how very important it is to ensure that your counterparty in a long-term trade of this nature is of the highest possible credit quality. Enron, never rated above BBB1 by the major rating agencies, conspicuously failed in this respect; there will be a number of "risk managers" caught with large exposures to Enron, who will face a very unpleasant time at the next Board meeting of their employers.
A further requirement that cries out from the Enron debacle, and from the other trading debacles listed above, is that the entities in the market have control systems of the highest possible quality. As I have written before, traders are naturally greedy, by the nature of the activity, and will seize any opportunity for personal profit that they can legally obtain, whether or not the opportunity benefits their employer. In particular, they will seize the chance to engage in "martingale" trading, which gives them a high probability of moderate profits and thereby good bonuses, at the cost of a small chance of catastrophic losses, which will bankrupt their employer, but lose them their job no more certainly than would moderate losses or even a break-even performance over a whole year. The battle between the traders and the control systems is continuous, so a trading operation needs both top-of-the-line control software and top quality top management in order to prevent the chance of catastrophic losses through misguided trading. In Enron's case, the control systems appear to have been inadequate even at the top management level.
A further iron economic law of trading operations is that they are a market share game. In the early days of a market, it is possible by rapid innovation to gain extraordinary returns, by doing things that your competitors haven't thought of. This is why derivatives were exceptionally profitable in the early 1980s and why Enron was able to grow so rapidly in the middle 1990s. As trading markets mature, however, and the useful innovations have been figured out (which in a given market, takes no more than 2-3 years) the profits go to the big battalions. Profits in a mature market, even one that is growing rapidly, are gained by knowing more about the patterns of activity in the market than your competitor. That knowledge is gained, purely and simply, by doing a higher share of the trades in the market. Hence trading, like many businesses but to an even greater degree, is an occupation in which high market share entities operate on far higher margins than small players. The result is, inevitably, concentration.
While something may happen to blow this prediction off course, therefore, the likely future of the traded energy and "bandwidth" markets is that they will continue to exist, and even flourish, but that they will become increasingly concentrated in companies, which have top quality credit ratings, state-of-the-art control systems and a substantial market share in the business. In general, that means the top end of Wall Street. Dynegy is unlikely to gain significantly from Enron's demise, because its own credit rating is also only BBB+ (close to the lowest "investment grade" rating).
It is thus likely that Dynegy, Williams (also BBB+) and their competitors will be bought by major Wall Street houses. They will not disappear altogether; their energy and "bandwidth" expertise is useful, because trading energy involves more complexity of delivery than trading say bonds. Thus the energy traders will have a better capability at key "back-office" functions than the major Wall Street houses. However, in terms of credit rating, sophistication of control systems, and, eventually market share, the energy traders will in the end by unable to compete with Wall Street.
Also expect the business to become further "commoditized" with only low profit margins available without undue risk. The one comfort for the Wall Street houses buying energy traders: the energy trading business should in general be nearly contra-cyclical to the stock market.
Finally, we have not heard the last of "moral hazard." Citigroup and J.P. Morgan Chase are both said to have had a $1 billion exposures to Enron. At some stage in the fairly near future the aggressive and often misguided lending and trading of by the big Wall Street houses is going to cause a collapse in one of the respective houses.
